Creativity maximizes pensions

March 4, 2013

Are you wondering how to make the most of your pension? If you're thinking about which income option to take, maybe it's time to think outside the box. Here's why.

When most retiring public service employees meet with a pension administrator and look over their income options, they face an either/or question. Do they sign up for the survivor's benefit or not?

You want to do the right thing. At first glance, it seems like a no-brainer. If you have a spouse, of course you want the survivor's benefit - right? After all, this is the option that guarantees the continuance of pension income for your spouse after you pass away. In most cases, it is structured so that the pension income lasts for the longer of two lives.

But do you really want to reduce your retirement income? You may not realize that this choice carries an opportunity cost.

If you choose to distribute your pension income under a "joint and survivor" arrangement, the monthly income you get will likely be hundreds of dollars less than if you had chosen a "single life" distribution. The pension fund knows that a joint life pension will almost certainly have to pay out over more years than a single life pension, so the monthly income will have to be set lower.

Selecting the joint life option means reducing your retirement income. If you take that option and die early, your spouse is looking at a lifetime of reduced pensions. If you and your spouse die a year or two apart, there is little benefit derived from the choice you've made. (In most cases, you can't reverse a pension payout option you selected years ago.)

If you choose the survivor's benefit, you are making an insurance decision. Seriously, you are. When you check that box, you are arranging for a cash benefit to be paid out to a surviving spouse. A life insurance policy has the same function - and it might be better to go get one.

The outside-the-box choice that is too often overlooked. Here's the real choice: Should you insure your spouse's future level of income, or should you insure yourself?

Let's put it another way. Let's say your spouse outlives you. After you die, do you want your spouse to receive some taxable retirement income, or a significant cash benefit that will not be taxed? (Life insurance proceeds aren't taxed, except in a few limited cases, but survivor pension benefits are.)1,2

Before you retire, you could purchase a whole life insurance policy in an amount that would give your spouse or your children the equivalent of a similar monthly benefit. That whole life policy could even build cash value over time.

Why insure your life instead of your spouse's future income level? This choice makes sense on many levels. First, you increase your retirement income by not choosing the joint life expectancy payout option. (If your spouse should pass away before you do, this will prove an even wiser financial decision.)

Second, you have a life insurance policy that will give your spouse financial protection in the form of a sizable death benefit if you pass away first. Your spouse could even use the life insurance proceeds to purchase an immediate annuity, which could then provide a lifelong income stream.

Third, if your spouse dies before you, you still have the maximum pension while the eventual life insurance proceeds may be directed to other beneficiaries you name on your policy such as your children. (Will your children inherit your pension income? No, they will not.)

Fourth, there's a lot of uncertainty today about the health of state and local pension funds. The less you have to worry about that subject, the better.

How would you pay for this new insurance policy? Well, it may be easier than you think. If you select a single life pension, the money you receive may result in income enough to live on and fund the policy.

Factors to consider. This "pension maximization" strategy makes the most sense if you and your spouse are in good health and if you are within 10 years of retirement. You also want to scrutinize the terms of your pension and medical plan, and take a look at the other income and tax consequences of making this move.

By the way, this strategy is common in corporate America. It's about time more public service employees used it as well. I urge you to look into it, and to discuss it with a financial advisor or licensed insurance professional.